Don't Let The New Tax Cuts Work Against You

Personal Finances

July 05, 2003|By KATHY M. KRISTOF Los Angeles Times

The new federal tax-cut package poses a dilemma for financial planners such as Scott Leonard.

Cuts in capital-gains tax rates and relief from the "marriage penalty" should spur many Americans to reorganize their financial lives. But many of the breaks are fleeting, changing or expiring at various times over the next 10 years through what are known as sunset provisions.

"It is extremely unfair to the American public to change the tax law every year, or have the changes evaporate after a few years," said Leonard, a certified financial planner with Leonard Wealth Management in El Segundo, Calif.

Even with the uncertainty, the new tax law does encourage some rethinking and rejiggering of investments, planners say -- especially since tax provisions that include sunset provisions are often revived or extended.

But certain strategies, especially those that rely on tax laws remaining consistent over long periods, may be risky.

"The tax situation has changed in a number of ways, but some of the changes are temporary, some may be made permanent, some may be improved even more," said Charles Foster II, a certified financial planner with Blankinship & Foster in Del Mar, Calif. "Our first advice to clients is to do things in moderation. Don't push planning so far in one direction that a change in the tax law could make what you've done foolish."

Here are a few strategies for taking advantage of the new tax cuts:

STOP FEEDING VARIABLE ANNUITY.

Tax-deductible retirement accounts remain a great deal, said Bernie Kent, a partner specializing in tax and financial planning at PricewaterhouseCoopers in Detroit. But nondeductible retirement accounts such as variable annuities are tough to justify.

Variable annuities are

investment accounts wrapped in an insurance policy. That insurance policy gives the investments tax-deferred status, and annuity owners can trade without paying current-year capital gains taxes on their profits.

However, the insurance coverage also costs -- an average of about 1.4 percent of the account's value each year. Also, money held in a variable annuity is treated like money in a tax-favored retirement plan, which means that when withdrawn it is subject to ordinary income tax rates, not the typically lower capital gains rates.

With capital gains rates slashed to a maximum of 15 percent, the tax disadvantages of annuities loom larger than ever, said Brent Brodeski, managing director of Savant Capital Management in Rockford, Ill.

Planners said they aren't necessarily advising clients to sell their annuities, because that could trigger both tax penalties and so-called surrender charges. But many suggested that clients stop putting money into them.

"The new tax changes should be the final nail in the coffin for the variable annuity industry," Brodeski said.

Some people still may appreciate annuity guarantees, which have become increasingly sophisticated in recent years, said Gumer Alvero, general manager and executive vice president of annuities for American Express Financial Advisors in Minneapolis. Those guarantees, which are covered by the insurance-policy portion of the product, can assure owners that their investments don't decline in value. But the greater the guarantee, the higher the price tag.

Particularly for buy-and-hold investors, the economic advantage of the annuity's tax deferral is largely wiped out by the higher fees and the higher tax rates in the end, Brodeski said.

MIDDLE-INCOME COUPLE? PAY OFF THE MORTGAGE

Congress attacked the marriage penalty by hiking the standard deduction for married couples by $1,550, to $9,500 -- exactly twice the amount for a single taxpayer. Congress also widened the 15 percent tax bracket for married couples.

These changes nearly beg middle-income couples, particularly retirees, to take whatever cash they have handy and use it to pay off the mortgage.

The old tax law already favored this approach, planners note, but the new law, coupled with low interest rates, makes it even more compelling. That's because taxpayers can claim the larger of either their itemized deductions -- mainly mortgage interest, charitable contributions, property taxes and business expenses -- or the standard deduction. With a higher standard deduction, it's tougher to reach the threshold where itemizing makes sense.

The wider 15 percent tax bracket also means that more income will be taxed at low rates, making itemized deductions comparatively less valuable.